Wednesday, 22 May 2013

It is a year since Facebook launched shares on the Nasdaq. They were launched at $38 per share and now stand at a lowly $26. Anyone who bought a share would have lost 30% of their money.

At first sight this looks like a classic example of the winners curse. The winers curse captures the idea that the winner of an auction often loses money. IPOs (initial public offerings) are a textbook example of this. Here's the basic logic: If you ask 1000 investors to put a value on Facebook then the average valuation will probably be about right. But, shares are not sold to average investors. They are sold to the investors willing to pay the most. So, what really matters are the valuations of the most optimstic investors. And while the average investor will get the value about right, the most optimistic investors will not. They will overvalue the company and consequently pay too much. This is the winners curse: the investors who 'win the auction' to get Facebook shares would have been better to not bother.

This is the textbook story, and it seems to fit the Facebook case pretty well. But, here are some things to add in to the mix.

One thing to consider is that the price of Facebook did increase in the first few minutes of trading up to $42, with a huge volume of orders. If you got a share at $38 and sold at $42 then that looks like good business. The stupid thing was to buy at $42! Its not clear whether buying the share after launch should be counted as the winners curse or a more general bubble effect that could be classified as irrational exuberance. I would call it the winners curse but others might not.

Another thing to regonize is that many IPOs run without any winners curse. For example, the chart below compares the performance of Facebook with Google, Linkedin and Manchester United. We can see that investors who bought shares in Google or Linkedin would have done very well. Similar things were expected of Facebook. This still means its relevant to talk of the winners curse - investors in Facebook lost money - but it does suggest that the winners curse is less prevelant in IPOs than some might have us believe.

A final thing to consider is the possibility of a 'winners bonus'. This is why I've put up the shares of Manchester United. The owners of United had originally planned to sell the shares for $16 to $20. They ultimately had to go for an underwhelming $14 (note that Google and Linkedin were launched at the top of their predicted range). Six months later the shares were up above $18. So, this is seemingly an example where easy money was there for the taking by buying the shares at a very low initial price. Clearly, the more that investors are caught by the winners curse the
more cautious we might expect them to be in the future. With Manchester
United they were seemingly very cautious. We essentially have the opposite of a winners curse.
I think there's an interesting lesson in all this with regard to the efficient market hypothesis. According to this hypothesis the share price of a company always reflects the underlying value of the company. In that case an IPO is akin to any other auction because you are buying a good that has value in itself - a share is analogous to a painting, car, house or anything else you can get at auction. In reality, most think that the efficient market hypothesis is pretty dodgy. The share price of a company is more likely to reflect the game going on in the market rather than the fundamental value of the company. The price at any one time may, therefore, be well above or below fundamental value. That makes an IPO different to standard auctions because you are buying a ticket to a game and not something of value in itself. And so, while the winners curse is still relevant, its effects are likely to be overwhelmed by the game playing going on.

Thursday, 16 May 2013

Earlier this week it the headlines that NICE (the National Institute for Health and Care Excellence) were recommending midwives use a carbon monoxide test to verify whether expectant mothers were smoking. Suitable fury from smokers followed. The proposal, however, is based on pretty sound economics.

The relationship between a child and parent is a principal-agent relationship. The basic idea of any such relationship is that a principal 'employs' an agent to do a 'job' for her. Its fine to interpret 'employs' and 'job' very loosely. In this case we can think of the unborn child as employing the mother to protect her growth and development. Clearly it is in the best interests of the child that the mother quit smoking, eat healthily etc. The mother, however, has different incentives. And, there were lots of mothers I heard on the radio this week determined to carry on smoking regardless. This is an example of a moral hazard problem: The agent, in this case the expectant mother, takes on more risk than the principal, the unborn child, would like her too.

Many people, at least many of the students I have taught, like to argue that the parent child relationship shouldn't be see as an example of a principal agent problem. Surely the mother acts in the best interests of her child? While, it would be nice to think so, the reality is often very different - count how many pregnant women smoke. So, moral hazard exists. And that's not the only problem.

People can choose when and whether to have children. If quitting smoking is difficult, then a responsible smoker would quit before getting pregnant. Some people do quit smoking before getting pregnant but others do not. Simple logic says that the people who get pregnant irrespective are going to have more children than those who wait until 'everything is right'. The adage that you cannot choose your parents, therefore, understates the true problem. You are more likely to be born to an irresponsible parent than a responsible parent! This is an example of an adverse selection problem: Less desirable agents are more likely to be employed. Or in this case, unborn children and relatively likely to end up with irresponsible parents.

We cannot, therefore, trust pregnant mothers (and fathers) to stop smoking. And a further thing to keep in mind is that the pregnant mother is employed by the taxpayer as well as the child. This is because the National Health Service will pick up the bill if anything goes wrong. That lessens the incentive for mothers to act responsibly. Indeed, one could argue that the benefits system positively encourages irresponsible behavior. So, I have no hesitation in saying that the carbon monoxide test is a good idea. The test, however, does not solve the problem of what to do with expectant mothers that want to continue smoking. For that the Health Service needs a credible threat to encourage non-smoking - and its hard to think how to do that.

Thursday, 9 May 2013

One of the big problems with US health care is the large number of uninsured people. A lack of insurance is costly for the state given that someone has to pick up the bill for all necessary treatment on uninsured patients. And its costly for society given that ill health can cause personal bankruptcy for anyone uninsured.
To fix the problem you need to know what is causing it. There are three basic causes. In looking through these its useful to have the following figure to hand. On the horizontal axis we plot the publicly observable health of the person, which might include things like weight, age, illness in the family etc. These are things the insurance company will take into account when assessing risk. On the vertical axis we plot the privately known health of the person, which also takes into account things like diet and exercise. These are things the insurance company would like to know but cannot, only the person knows. Each dot in the figure is a particular person. Most people will be near the 45 degree line, but not all. For example, Fred is very healthy, exercises regularly etc, but looks very risky, because of say a genetic condition in his family. John, by contrast, is very unhealthy, eats fast food every day etc., but the observable characteristics make him look healthy.

Now, to the causes of people being uninsured:

1. Some people look such a high risk that no insurance provider is willing to provide insurance. In the figure I have drawn a cut off point at N. No person beyond this will be given insurance. That's clearly harsh on Fred who is perfectly healthy. The problem is, the insurance cannot know that Fred is healthy because everyone can lie about taking exercise and eating healthy etc.

2. Adverse selection. Suppose the insurance company offers a standard price on insurance to anyone left of N. The price will be based on average health and so will look unfairly high to someone like Sarah who knows they are healthy. Sarah exercises regularly, eats healthy, and objects to paying a high price because others take less care of their health. As such, Sarah may choose to not buy insurance. This can push up the price of insurance even more given that those left buying it are the relatively unhealthy. In the figure anyone below H is assumed to not buy insurance because the premiums are too unfair. (This story assumes a standard price for everyone and the insurance company might charge according to risk. The basic logic, however, still follows through.)

3. Some people are risk loving. John, for example, might just risk that he can avoid ill health. Of course, a little bit of over optimism and present day bias is likely.

All three of these potential causes are surely at work in the US. So, how to fix them? Europe has a relatively simple answer - force everyone to get insurance. This can be done implicitly as in the UK through taxes or explicitly as in the Netherlands. Obamacare essentially tries to bring this philosophy to the US. How does this work? It solves problem 1 by guaranteeing everyone access to insurance. It solves problem 2 by forcing people to pay even if prices are unfair. It solves problem 3 by forcing people to buy insurance whether they want it or not. It is these last two sentences that capture a lot of the hostility towards Obamacare we see in the US. Why should people be forced to buy insurance against their will?
Problem 3 is almost certainly due, in large part, to cognitive bias. Many people who risk no insurance may subsequently regret that decision. So, it is not unreasonable that the government forces people to make the right decision, particularly as the government picks up the bill. Problem 2 is a market failure. Forcing people to buy the insurance solves the problem. It has the advantage of lowering prices because healthy people are bought back into the market. Prices still remain unfair for people like Sarah, but they are less unfair than they would have been otherwise. And note that everyone benefits from the lower prices including those who were buying insurance previously.
So far, so good. Fixing problem 1 is where the problems start. Morally, it seems easy to justify everyone having access to insurance. The drawback is that it brings the least healthy people into the market. Which can increase premiums for everyone, offsetting the gains from solving adverse selection. Recently, the Society of Actuaries predicted that insurers costs will jump by 32% by 2017. This increase is partly due to the increased risk for insurers of bringing less healthy people into the market. If that increase in costs is passed on in premiums in the private insurance market then there will be many unhappy people.
Remember, however, that a lack of insurance has big costs. The savings the government makes, if everyone has insurance, should be enough to reduce insurance premiums through direct subsidy. In short, if the amount of treatment remains the same, there is no reason total health care costs should increase. All that's happening is a redistribution of the costs. The previously uninsured are paying where they did not before, and the government has savings that could be put back into the system. Compulsory insurance is not, therefore, as bad as the critics would suggest. And it is surely a fairer system? It forces people to buy insurance, but also means taxpayers are not forced to bail out the uninsured.